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In a pair of recent posts (here and here), Matt Yglesias embraces one of the most pernicious and destructive fallacies of economic thought: the proposition that prices “should” equal marginal cost. As my colleague Solveig Singleton explained in “Is Cheaper Always Better? Misusing the Concept of Marginal Cost in Policy Discussions,” the idea that “efficiency” is reached by the P = MC equation is true only in an abstract world of unrealistic and static assumptions, but the persistence of the myth continues to cause great damage.

Does the concept of static efficiency or marginal cost have *any* appropriate uses? Rarely. . . .

Models of perfect competition and the concept of marginal cost have some power to explain some of the forces at work in real markets, but they are not a sound normative measure of what the real world ought to look like.

For more discussion, see “Marginalized,” and for a real coup de grace see the eminent economist William Baumol’s 2006 monograph for AEI, How Regulators Can Be Misled By Simplistic Theory, which warns:

Only this year I heard a conference presentation dealing with the economic and legal principles of copyright suggest that the innovating Schumpeterian entrepreneurs are automatically to be deemed proper subjects for antitrust attentions because in the period before imitators enter the market, they can charge prices that exceed the marginal-cost levels of perfect competition. Never mind that this is a prescription for undermining intertemporal efficiency. Never mind that marginal-cost pricing would generally preclude recoupment of the research and development (R&D) costs of the innovations at issue, costs that will have to be incurred many times again if innovation is to continue.

Baumol is too kind in limiting his indictment to “some economists” who are “not as careful as they should be,” because the fallacy and its consequences are woven into a great deal of professional analysis and policy recommendations, not to mention most of antitrust.

Six years ago, the Competitive Enterprise Institute (CEI) did an excellent workshop on Declining Marginal Cost Industries, featuring talks by giants Ronald Coase and Lester Telser. (Disclosure: I helped Fred Smith put it together.) The descriptive blurb notes:

The declining marginal cost problem remains the key challenge to a range of industries. As Ronald Coase long ago noted, a declining cost industry must find some way to finance itself: either via creative multipart pricing (facilitated by bundling or contracts) or via some form of government subsidy. The markets solution has traditionally relied on distinct marketing strategies in different geographic regions and to different segments of the markets, with market segmentation facilitated by the high costs to consumers of transport and/or the difficulty of acquiring information about the prices paid by others. The government subsidy approach inevitably entails government regulatory and /or price controls (there are no “free” subsidies). Clearly, we prefer the market solution.

Phil, apropos of your post on the Toyota recall and the strangeness of attempting to draw “a sharp distinction between American and foreign auto producers,” there’s this gem (H/T Pletka):

The UAW and the Teamsters union protested outside the Japanese Embassy in Washington today calling on Toyota to reverse decisions to close a California plant and hire nonunion carhaulers . . .

[UAW Vice President Bob] King and other union officials linked Toyota’s recalls to the management decisions made to close down the California plant, saying both were examples of how Toyota had strayed from its principles.

“It’s a Toyota decision. It’s Toyota engineering that’s creating havoc with consumers in America,” King said.

So they hold a protest at the Japanese embassy? As you point out, if anything it’s American engineering “creating havoc with consumers in America.” Given the bad faith of the UAW and the Teamsters in this instance, is it any wonder Toyota wants to move its plant to a right-to-work state?

Last year, when President Obama was buying up car companies, he spoke of the need to preserve the American automobile industry. At the time, he clearly meant Ford, Chrysler, and General Motors. That was odd even then, given the substantial production of foreign-owned companies like Toyota and BMW in the United States and the worldwide manufacturing model that all these companies employ.

The attempt at a sharp distinction between American and foreign auto producers looks even stranger in light of Toyota’s recent accelerator-pedal disaster and recall. Toyota has gained market share for years at the expense of behemoths like GM. In large part, these gains built on a reputation for quality. At first blush, it would seem that recent episodes in which accelerator pedals have reportedly stuck in some Toyotas, killing or imperiling those within, would mark a major setback for Japanese producers and offer an opportunity for U.S. competitors.

But nothing is so simple in the globally interconnected world of auto production. It turns out that those dubious Japanese accelerator pedals were actually made by CTS Corp. of Elkhart, Indiana. The manufacturing takes place at a plant in Canada. The Toyotas that are thought to be immune from the problem are those with pedals made by the Japanese supplier Denso. In fact, it was a shortage of Denso pedals that compelled Toyota to halt vehicle production.

Could it be, though, that U.S. producers at least chose their suppliers more wisely? No such luck. Ford just announced that it was stopping production and sale of a commercial vehicle in China, because it uses pedals made by CTS.

Image by Chris 73.

Congratulations are in order to Federal Reserve Chairman Ben Bernanke on his confirmation this afternoon by the Senate on a vote of 70 yeas and 30 nays. Unfortunately for him, commiserations are also in order because he has to lead an institution that is currently held in low esteem by the public and will almost surely see some of its independence eroded by a hostile Congress.

The tally of 30 votes in opposition sets a new record of negativity for a chairman’s confirmation, but it will do nothing to influence Bernake’s place in Fed history. After all, the prior record holder is Paul Volcker, whose reputation is secure.

The confirmation controversy was never about the person but rather about the institution. It was Bernanke’s misfortune that the calendar page on his term turned as unemployment holds at 10 percent and public outrage about the unfairness of protecting big financial firms is swelling. The Fed chairman was a fellow traveler in those ill-designed rescues, which were often opaque as well as unfair, but the blame should be spread across several institutions and actors.

A short list of Bernanke’s coming challenges is to hold off pressures for a premature exit from Fed accommodation, to use the new tool of interest on reserves to tighten the stance of policy when the appropriate time comes, and help to shape change in the Fed’s powers.

Change is inevitable. Hostility toward the Fed is too great among the voting public for the Congress to end the year without delivering legislation that reshapes and delimits its powers. The Fed would be best served if Bernanke dropped his defensiveness about the current structure of the institution. Repeating rote justifications for preserving all the Fed’s powers will only alienate those on Capitol Hill. Rather, the newly reconfirmed chairman should open a dialogue to protect the Fed’s core responsibility of monetary policy and make the structure of supervision and regulation across the government more efficient.

One real question about the State of the Union speech was what Democratic moderates made of it. Between several criticisms of the Senate and President Obama’s insistence that healthcare would proceed much along the lines that it has for the past several months, the president clearly indicated that the Massachusetts election would not make him change course. The members in the most difficult position are moderate Democrats, many of whom are, after Massachusetts, more squeamish in supporting healthcare and other initiatives.

Obama’s stay-the-course message was meant to reassure the base that he was sticking to his principles, but did not give much cover to moderate Democrats who will be the key, tough votes if the president continues to pursue his healthcare plan.

Every SOTU address has a handful of paragraphs that were drafted by a committee—and they usually expose issues where the president just doesn’t care enough to question the words on the page before he speaks them.

A couple of our Latin American neighbors got the brush off in this paragraph that was nuanced to within an inch of meaninglessness.

If America sits on the sidelines while other nations sign trade deals, we will lose the chance to create jobs on our shores…. And that’s why … we will strengthen our trade relations in Asia and with key partners like South Korea, Panama, and Colombia.

Nice words, I suppose. But the president doesn’t actually come out and ask Congress to ratify trade agreements with these countries, which were negotiated by President Bush and which have been languishing in the Congress for years. (Speaker Nancy Pelosi rewrote the “fast track” rules of the House with the express aim of shelving the trade accord with our best ally in the Americas, Colombia; last night, she choked when the president mentioned Colombia but recovered when she realized that he didn’t actually endorse the accord.)

A very compelling fact is that Colombia is a key ally in the fight against drugs and terrorism and faces almost weekly bellicose threats from President Hugo Chavez in neighboring Venezuela. Panamanians recently elected a new pro-American president, who was the object of a kidnapping plot discovered last week involving foreign-backed narcoterrorists. Ratifying both of these agreements now would send a very clear signal that these are strategic partners that enjoy our unmitigated support, which could back off warmongering by Chavez and other thugs. Instead, the Obama drafting committee opted for words that would pass muster with the anti-trade union bosses but left the president looking less than serious.

As a result, leaders in three friendly countries are left scratching their heads and wondering where they stand with us. Aren’t we supposed to sow doubts with our enemies and embolden our friends?

While President Obama made clear in his State of the Union speech that he intends to stay the course with respect to most of his domestic policy priorities, it was striking that his “third” priority was international trade and that he even mentioned it all. In fact, he explained that his administration’s “new goal” is to “double our exports over the next five years” by launching a “National Export Initiative.” He also raised that it is to our detriment “if America sits on the sidelines while other nations sign trade deals.” In this vein, while noting that we need to step up enforcement of our trade deals, he mentioned the importance of the U.S. role in the Doha trade talks and of strengthening “our trade relations in Asia and with key partners in South Korea, Panama, and Colombia.” Interestingly, those who rose to their feet to applaud were not members of the president’s party.

While it may seem that the president is planning to change course on trade, the Obama administration is likely to stay the course on this issue, too. It’s no secret that trade has simply not been a priority over the past year. And, in this election year, it is hard to see the president expending his increasingly limited political capital on pushing a politically costly trade agenda because (1) regardless of the administration’s ambivalence on trade, the president faces a Democrat-controlled Congress openly hostile to trade; (2) there are domestic policies like healthcare and energy which are of far higher priority and which will require significant amounts of political capital; and (3) the risk of alienating anti-trade Big Labor, which has to date exerted inordinate influence over this administration’s policies, endangers support of those who will be the foot soldiers for the embattled Democratic Party in this fall’s midterms.

We should take the president’s statements on trade as simply grandstanding. Really. After all, he only said we needed to “strengthen” our trade relations with South Korea, Panama, and Colombia. He did not encourage Congress to pass these pending free trade agreements or say that U.S. negotiators planned to make landmark proposals to move the Doha trade talks forward. It is certainly hard to imagine the doubling of exports in five years without concluding new trade deals that allow enhanced market access to U.S. exporters. But, by the time that deadline rolls around, President Obama will either be coasting in his second term or be out of the limelight. The promise is of little consequence—politically.

Rather than admitting the obvious—that Democrats have substantially overreached on healthcare—the Obama administration’s initial response to Scott Brown’s election in Massachusetts was that it had failed to explain adequately the benefits of Democrats’ healthcare overhaul bills. The president reiterated this excuse in his State of the Union address, with no indication of any willingness to compromise to achieve bipartisan reform. Instead, he wants “everyone to take another look at the plan that we’ve proposed.” Looking directly at Republicans, the president arrogantly and sarcastically challenged: “But if anyone from either party has a better approach that will bring down premiums, bring down the deficit, cover the uninsured, strengthen Medicare for seniors, and stop insurance company abuses, let me know.” His subsequent plea “to come together and finish the job for the American people” rang hollow. The American people spoke last week.

Substantively, there were three threads that ran through the domestic part of the speech:

1.  A frequent abstract appeal to national nobility, unity, and other focus-groupy buzzwords, unconnected to any discernible concept of how government should interact with its citizens or create structures within which they can seek their own ends. There was a good bit of “I love America.”

2.  A virtual certainty that whenever specific ideas were proposed they would be bad ones, designed primarily to benefit worthy constituencies. To wit:

– Education came out the best, as even more money is to be shoveled out to colleges and the professoriate, in the form of tax breaks for students. (The idea that higher education needs to be disintermediated by the Internet is too awful to be contemplated.) Government agencies and their employees, who will be given even more authority over chunks of the economy and extra breaks on student loans, also came out well.

– Improved infrastructure was mentioned, and then defined as boondoggles such as high-speed rail and clean energy. (He did mention nuclear, off-shore oil, and coal, but don’t hold your breath.) Clean energy came out well indeed, because its promotion is also defined as “innovation,” as in the need to improve our national record on innovation. News has not penetrated the Oval Office about Climategate, the disappearing-glacier hoax, the extreme weather fictions, and the rigged temperature record: Obama is still all-in on climate change.

– The campaign finance decision is to be attacked, something much to the advantage of the Dems, with their backers in the public sector, the media, and Hollywood.

– Small business received some promises, too, probably because that wheel is squeaking loudly, and the ever-morphing healthcare bill is now a way of reducing middle-class insurance premiums.

– We are to double exports, by fiat, and apparently with the help of another government agency.

3. Sleight of hand—discretionary expenditures will be frozen, so money for favored groups will take the form of tax breaks, or, in the case of a proposed $30 billion fund for small business loans, by taking it from the big banks.

The State of the Union address is usually stultifying, so perhaps it is not fair to apply any but the most tolerant standards. But the address certainly triggered déjà vu, as if we were back in the 2008 hopeychange campaign and the intervening 18 months had not happened. And, as so often happens an hour after eating an Obama speech, one can’t quite remember what was on the menu.

From some on the Right, I expect we’ll hear a different argument—that if we just make fewer investments in our people, extend tax cuts for wealthier Americans, eliminate more regulations, and maintain the status quo on healthcare, our deficits will go away. The problem is, that’s what we did for eight years. That’s what helped lead us into this crisis. It’s what helped lead to these deficits. And we cannot do it again.

Followed by…

I will not give up on changing the tone of our politics.

Watching the president and vice president on TV and hearing Obama talk proudly about their “leadership” and how they promised “change you can believe in,” I can’t help but remember how relatively uncharitable they have both been in the past when it comes to spending their own money to bring about change with private charity. If we look at the period before the 2008 election, in some of the years when nobody was paying attention to their charitable giving, public records show that:

1. Between 1998 and 2006, the Bidens’ adjusted gross income (AGI) averaged $236,000 per year, and their average annual charitable contributions averaged just $283, or only $5.44 per week. That compares to an average annual charitable contribution of $1,916 for taxpayers with AGI between $15,000 and $30,000 (according to IRS data). In other words, taxpayers in one of the lowest income brackets ($15,000 to $30,000) were almost seven times as generous as the Bidens, with only about 10 percent of their income!

2. The Obamas were a little more generous than the Bidens, giving an average of $2,187 annually ($42.06 per week) between the years of 2000 and 2004, on average annual AGI of $243,000. That means the Obamas, with income that put their household in the top 2 percent of American families, were just barely more charitable during that period than those Americans making less than $30,000 per year.

Their own tax returns demonstrate that when Obama and Biden talk about change, they really only believe in the kind of change that involves spending somebody else’s money, and not their own.